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When are you most likely to do a reality check on your investments? Is it when they’re doing well? Or is it when the markets are down and you’re nervous? Chances are it is the latter, which may not be the optimal time to make investment decisions, particularly if emotions are high. That’s why taking the time to do an annual review of your investments and other financial matters makes sense.

Careful planning is essential in all economic climates. Think of it as if you were driving on a dangerous road. That’s not when you check your brakes and tires. You do that before, so you know they are in good shape.

An annual financial checkup can accomplish many things. You can stop and think about your family’s financial goals, such as saving for retirement, a house, or a child’s education. You can consider reducing taxes on your investments, protecting your income, or building a financial cushion. Once you are clear on your goals, you can then work on ensuring that you are investing appropriately for those goals. And while you are looking at your accounts and holdings, take care of “housekeeping” items, too, like checking beneficiaries and completing a health care proxy, which are not complicated but can have serious consequences if neglected.

Here are five questions to ask when you do a financial review.

You probably have several savings goals and accounts. Your annual financial review should revisit each of your priorities and your strategy for reaching them. If your conditions have changed, make adjustments as necessary.

At least once a year, check your target investment asset mix to ensure that it continues to meet your time frame, risk tolerance, needs, and preferences, and to perform any rebalancing that might be necessary in light of the past year’s market performance.

On your own or with your adviser, take some time to look at specific investments and evaluate whether they continue to have a role in your portfolio. It’s important to match your investments to certain time frames or specific goals. Some may be long-term such as saving for a child’s education or your retirement. Others may be more short-term such as saving for a new car, a vacation home, or travel.

For example, you may take on more risk saving for a retirement that is decades away, but you may want more conservative investment options to fund 25% of a grandchild’s college education in five years. Or, you may earmark $35,000 from a particular fund this year to pay for a new car for your spouse.

Tips:

• Contact A.D. Financial Planning to set up a no obligation meeting. The A.D. Financial Planning process begins with an in-depth discussion about your personal goals and objectives.  Our understanding of your unique situation assists us in creating a financial plan that addresses your personal desires, needs and values. To learn more, visit our planning process page.

What strategies are you exploring to help defer, reduce, or more efficiently manage taxes on your investments?

The overall impact of taxes on performance can be significant: Morningstar cites that, on average, over the 88-year period ending in 2014, investors gave up from one to two percentage points of their annual returns to taxes. Although you cannot control market returns or tax law, you can control how you use accounts that offer certain tax advantages. This type of approach is often referred to as active asset location. Employing this strategy allows you to choose which assets to keep in your tax-advantaged accounts and which to leave in your taxable accounts. In general, the more tax inefficient an investment is, the more tax you pay on it.

Our basic rule of thumb is to put “tax inefficient” investments which generate taxable income—like taxable bonds and Real Estate Investment Trusts (REITs)—in tax-deferred accounts like 401(k)s and IRAs. For those investments which are more “tax-efficient”—like stocks and ETFs held for more than a year—place them in taxable accounts.

Are you already taking full advantage of a 401(k) plan, Keogh, IRA, or other qualified account that may be available to you? Generally, these accounts are the best place to start a program of active asset location, because of their tax advantages, but each comes with contribution and withdrawal restrictions.

If you are entering retirement and transitioning from saving to spending, a tax-savvy withdrawal strategy can help your savings last through retirement. While the traditional withdrawal hierarchy of taxable, tax-deferred, and tax-exempt assets is a good starting point, individual situations and changing circumstances may require making adjustments. Aim to withdraw no more than 4%–5% from your savings each year to help ensure that your saving will last for a 20–30 year retirement.

Tips:

• Read: Traditional or Roth?
• To discuss retirement savings or just where to begin on your path to financial freedom, contact A.D. Financial Planning.

You’ve worked hard and want to protect your income. So it’s wise to evaluate your family’s total insurance needs annually to make sure you have the right amount and type of insurance to cover unforeseen circumstances that can derail a financial plan.

Life insurance may be a good place to start. If your family is growing, you might want to increase the amount of your life insurance to protect your loved ones. On the other hand, many people find as their net worth climbs and their children reach adulthood, they need less life insurance.

If you choose to reduce your life insurance, you may want to apply the savings toward your health insurance, which becomes more critical as you age and continues to increase in cost. You might also benefit from looking into long term care insurance, which may offer a variety of features and options.

One more thing: Your annual review should also include a simple check of your insurance beneficiary designations to see whether they are up to date.

Tips:

• Read “Life insurance buyer's guide: What type, how much and who will benefit.”
• Contact A.D. Financial Planning to help you determine how much insurance you need.
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Use your annual review to make sure you have an estate plan, and that it continues to reflect your family status and financial situation. Ensure that it helps make the best use of the latest estate and tax laws, and that key individuals know where to find relevant documents and information.

If you do have a plan, do the people you care about know about it? Where is it, and what role should your loved ones play if something happens to you? Marriage, divorce, birth, and death are the four big events that affect estate plans, but you may also want to consider other factors, such as longevity and health, that could affect your planning.

Thinking about a will, health care proxy, and power of attorney can be uncomfortable, but consider the alternative. Do you want someone else making these decisions for you? If you don’t have any of these key documents, take the time to set them up. If you have them, review not only your paperwork but any life events that have occurred. Moving, having children or grandchildren, or losing a loved one can have a big impact on your plan overall.

Tips:

• Read "Head off squabbles among your heirs."

It’s not just your retirement or financial future that you are planning for. You are likely researching and cultivating strategies to provide financial assistance to parents, children, or even grandchildren. Beyond college, a lot of parents are helping to launch their millennial children into the world of fully independent living. Meanwhile, many have aging parents who can no longer live on their own or manage their own financial and personal affairs. Will caring for others affect your financials goals, priorities, and outcomes?

An annual review can help prioritize financial decisions that you need to make to support your family’s goals across the generations—and help tee up long-neglected family money conversations. It can help you bring your family together to sort through vital matters related to such things as college savings, care-giving responsibilities, health care decisions, estate planning, and the tax implications of an inheritance.

Take a long-term view for your family

While all this might sound like a lot of ground to cover, an annual review is well worth the effort when you consider the hard work you have invested in building and protecting your wealth. A.D. Financial Planning knows it is important to have a long-term view of your financial strategies and enjoy meeting with our clients during their annual reviews. The annual review is an opportunity for you and your family to evaluate your current goals and objectives, and to reassess your investment and financial situation, while also thinking about planning for the future with a knowledgeable professional.

Learn more

• Learn why a fee-only financial planner is the smart choice by reading, "Why Fee-Only Matters."
• Understand what a fiduciary is and why you want working for you. 

• Traditional IRAs
• Rollover IRAs
• Inherited IRAs
• SEP IRAs
• SIMPLE IRAs
• 401(k), 403(b), and 457(b) plan accounts
• Keogh plans

In 2016, on top of the $18,000 regular limit to a 401(k) plan, workers 50 and older can add $6,000 per year in catch-up contributions, which are aimed at helping individuals save enough for retirement.

Contributions are tax-free, but withdrawals are taxed as income in retirement. (Individual Retirement Accounts (IRAs) also allow catch-up contributions, but only at $1,000 per year, on top of the regular $5,500 limit.)

The additional 401(k) savings could amount to an additional $1,000 per month once a worker enters retirement, according to calculations done by Fidelity, one of the largest holders of retirement accounts.

Most employees, however, do not even come close to the regular limit, let alone put in extra.

According to new data from Fidelity, just 8 percent of its clients who are 50 and over make use of the catch-up program. Vanguard found in its last "How America Saves" report that 16 percent contribute.

While those numbers sound really low, Vanguard says there is a rosier picture in certain demographics. Among those 50+ who make more than $100,000 per year, the participation rate was 42 percent.

Income matters

If you make less than $100,000, maxing out a 401(k) and then adding catch-up contributions would mean saving more than 20 percent of earnings. But the national average of people who max out at the regular limit is just 9 percent, according to Fidelity.

Those easiest to reach may be the 10 percent of workers Fidelity found who max out the regular contribution but do not do catch-ups once they hit 50.

Unlike a Roth IRA, you do not become ineligible for a 401(k) as your income rises. While there is a bottom end of the income spectrum who opt for catch-ups, there really is no top. Somebody earning $300,000 is still considering a 401(k) strategy, but it is more about the tax benefit — not that they need to save more money."

Fidelity found that the average 401(k) balance of those doing catch-ups was $417,000, versus $157,000 for those who did not. That's a big difference and it's easy to see which account balance you'd rather have.

Contact A.D. Financial Planning, we can help you get started on saving for retirement or give you a second opinion on your current savings plan.

When the funeral is over, the drama is just beginning. Maybe it's a brief tug-of-war over Grandma's handwritten recipe book. Perhaps it's a heated debate among siblings who have jointly inherited a family vacation home and can't agree on whether to keep it or sell it. Or maybe it's an epic family legal battle sparked by a disinherited son who decides to contest a parent's will.

Focus on retirement

More on retirement topics — from planning to spending, and other issues that affect you.

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A growing number of adult children are providing care for elderly parents, and they may feel resentful if they have to share an inheritance equally with siblings who didn't help out. The rise of "blended" families, where at least one spouse has children from a previous marriage, also creates inheritance issues that can end in bitterness. Nearly one-third of people in blended families say that there are conflicts among their potential heirs, compared with 12% in traditional families, according to a survey by UBS Wealth Management.

No matter how harmonious your family, you shouldn't assume you're immune to inheritance battles.

Start talking

Because poor communication is a primary cause of inheritance conflicts, you should consider involving your potential heirs in your decision-making process as you create your estate plan. First, decide who gets to have a voice in the process. If you're including your favorite daughter-in-law but not your less-esteemed son-in-law, you may be laying the groundwork for future conflict.

You may want to give heirs some sense of how much they're inheriting, because even positive inheritance surprises can lead to family feuds. Often, when a parent dies with far more money than the children anticipated it can create a "feeding frenzy."

Also talk to heirs about the goals you're trying to accomplish with your estate plan. If you plan to leave significant assets to a charity, for example, you may want to tell heirs about your decision and why the cause is important to you. People dispute things when they don't have an explanation.

Having an open and honest conversation can prevent arguments over an estate, even when the amount given to multiple children are not equal. One retired mother told her children that she won't be dividing all of her assets equally. She's hoping that her IRA will help cover college costs for her grandchildren, so she's leaving the greatest share of that account to the child who has four kids, a smaller share to the child who has two kids and the smallest share to the child who has only one kid.

Her children have raised no objection to her estate plan, and they've made the process easier for her by telling her which personal items they want. One wants the music box, another wants the dining room table, and the third wants the tools. By talking opening conflict can be avoided.

Tamp down likely trouble

Conflicts can't always be avoided. You can't erase a sibling rivalry that has kept your children at odds for decades. Even a perfectly equal division of your assets may leave one heir feeling he didn't get a fair shake -- as when a child who's struggling financially gets the same inheritance as a wealthy sibling.

If you foresee conflict among your children, don't name any of your children as executor. Turn to another relative or trusted friend instead.

Also consider transferring your assets into a trust. A revocable living trust lets you remain in control of the assets and offers greater privacy than a will, potentially heading off disputes after you're gone. A will must be promptly filed in court after your death, so it becomes a public document -- inviting scrutiny and potential objections. With a trust, your estate details remain private, and the trustee only needs a death certificate to start carrying out your estate plan. 

For added insurance against conflicts, you can appoint an independent trustee such as a financial institution, or appoint a relative who is not a beneficiary under the trust.

To discourage heirs from objecting to your will or trust, consider including a "no contest" clause stating that an heir who challenges any provision gets nothing at all. Enforcement of these clauses varies from state to state, so seek a lawyer's advice. Even if you'd like to disinherit a child, plan to leave something to him. That way he's covered by the no-contest clause. 

When equal is not fair

Like the mother mentioned earlier, you may have reasons to leave children or grandchildren unequal shares. Perhaps one of your daughters has sacrificed her own job to provide care for you as you age, and you want to reward her with a larger inheritance. Maybe you made a loan to a son that hasn't been repaid, and you think that amount should come out of his inheritance. Or perhaps you want to disinherit a child altogether.

Ideally, you can communicate openly with heirs about your decision. Including in the will some brief explanation of your decision to leave unequal shares can also help avoid disputes. You can leave a longer explanation in a separate letter to your executor, requesting that a copy be given to each heir.

Before treating children unequally, however, you might consider alternatives. If one child is providing a lot of care for you, for example, you can compensate her during your lifetime through a "personal care agreement." This agreement details the services that the caregiver will provide and the amount of compensation she'll receive. The compensation, which will be considered taxable income for the caregiver, should be in line with what you would pay a third party for the same services in your area.

If you are lending money to a child and expect to be repaid, make sure that there is documentation. Create a promissory note showing the amount of the loan, the repayment schedule and the interest rate, if any. If the money isn't repaid during your lifetime, your estate plan can provide that the child's inheritance will be reduced by the unpaid loan amount.

You may unwittingly create big disparities in the inheritance left to various children if you add one child's name as joint owner of your bank account. You may be doing it for convenience, so that child can help you manage your finances. But when you die, the account will generally automatically go to that child rather than your estate. This can generate some hard feelings. Consider granting the child a financial power of attorney rather than making him a joint owner of your accounts.

Dividing the stuff

The fiercest inheritance battles can revolve around items that have little monetary value. If you didn't give any guidance on who should get Grandpa's pocketknife -- because you didn't think anyone cared -- your kids may wrestle over it when you're gone.

You can write a list of your personal property and how it's to be distributed. Sign and date the document, refer to it in your will, and update it as often as needed. When children see that, a lot of times they say, "If this is what Mom really wanted, I won't cause any problems."

You probably don't want to dictate how every knickknack should be distributed. After including the more significant items on your personal property list, you can leave it up to your executor to distribute the rest of your personal items. Your will can also give some guidance on dividing all the property and settling any disputes. If more than one heir wants the same item, for example, they could bid for it in a private auction, with the money going into a pot that's distributed among heirs. Or heirs can simply take turns choosing items, drawing straws for the first pick.

A workbook, Who Gets Grandma's Yellow Pie Plate?, offers suggestions on distributing personal property and managing conflicts. Free online resources are also available at www.yellowpieplate.umn.edu.

The big-ticket items

Real estate often becomes an inheritance battlefield. Vacation homes, for example, are fraught with all kinds of controversy, because heirs may not agree on how they'll use the property or how much it's worth.

One individual had several vacation homes that he considered roughly equivalent in value, so he left one to each of his kids. But because the children did not think the homes were of equal value, his efforts to be fair led to a family squabble. If you have several properties to distribute among heirs, consider getting them all appraised. If there's a significant difference, you can give some additional assets to the heir who gets a property of lesser value.

Leaving a vacation home to multiple heirs can also ignite feuds. Heirs may not agree on how to use the property -- for example, renting it out or keeping it for family use. Or one heir may want to sell the house, while the other is determined to hold on. In that case, the heir who wants out could force the sale of a home that's been in the family for generations.

If you plan to leave a home to multiple heirs, it often makes sense to put the house in a limited liability company and then leave interests in the LLC to your heirs. The LLC's operating agreement will govern issues such as scheduling use of the property, maintenance and how one heir can sell his interest to other heirs. You'll need a lawyer to draw up the operating agreement, but you and your potential heirs can decide on many of the details together.

Blended families

If you have remarried and have children from a previous marriage, maintaining harmony among heirs may be particularly challenging. And only half of people in blended families say that they have open discussions about inheritance, compared with 65% of traditional families, according to the UBS survey.

When both spouses have children from previous marriages, the problems can be compounded. If you're about to enter a second marriage, a prenuptial agreement can set aside specific assets for your children from a previous marriage and spell out exactly what a second spouse is entitled to when you die.

Another option: a marital trust, which can help you provide for your new spouse after your death while also ensuring that your children from a previous marriage receive an inheritance. These trusts come in various flavors, but blended families often use a qualified terminable interest property trust (QTIP), which can provide income to your surviving spouse for her lifetime while preserving the underlying assets for your children from your first marriage.

Be sure that beneficiary designations on all of your retirement accounts, brokerage accounts, annuities and insurance policies are updated to reflect divorce, remarriage and other life events. If you don't keep designations up-to-date, your ex-spouse can in some cases wind up with a share of your estate -- no matter what your will and divorce decree say.

Contact us, A.D. Financial Planning can help you with ideas for your estate planning.

You've probably seen the life insurance commercials in which small children, all wide-eyed and adorable, ask questions like, "Hey, Dad, what's life insurance?"

While these campaigns are supposed to put a small lump in your throat, most people don't think about life insurance until they absolutely have to. That usually happens when their financial well-being becomes increasingly intertwined with someone else's, which can come with getting married, buying a home or, the big one, bringing a child into the world. 

Those happy events don't make the task of buying life insurance any more pleasant — just more urgent.

It is one of those things that people put off. Most people are surprised about the amounts they need and often think because they have coverage at work, it's enough.

That's hardly ever the case. So consider this a back-to-basics guide that will help sort out what you need as quickly and efficiently as possible. Buying insurance has a lot in common with ripping off a Band-Aid: You just need to do it and then get on with the business of living.

Below are answers to some of the most common questions that are likely to arise:

What type do I need?

Most people are best served by a plain-vanilla term insurance policy. At least that's what many financial planners, like me — who are paid a fee for their advice — will recommend. As the name suggests, these policies pay a set amount if the policy owner dies within the boundaries of the term, typically somewhere between 10 years and 30 years.

Term insurance is simple, the policy features generally don't vary greatly across providers (other than the cost), and it's cheap compared with other types of insurance.

A healthy 30-year-old woman might pay $38 a month for a $1 million policy with a 20-year term (men pay $10 more), according to PolicyGenius, an online insurance brokerage. A 45-year-old woman might pay about $48 a month for a $500,000 policy with a 20-year term ($60 for men). Smokers can expect to pay two to three times as much.

But don't be surprised if you find yourself sitting across the table from an insurance agent who tries to push a permanent insurance policy, like whole life or universal life insurance. Those policies generate higher commissions, so there's that temptation for the agent.

And even if the agent truly believes in the merits of permanent insurance, which can accumulate a cash value, it is far more expensive, often costing several thousand dollars a year.

Permanent life insurance can, however, be the right choice for people who will always have a need for life insurance. They might include the parents of a child with special needs or a wealthy family who will owe estate taxes.

How much to buy?

The rule of thumb tossed around most often is to buy coverage worth 10 times the policyholder's salary. But each family's needs will vary depending on what amount of income the family is seeking to replace and what other items family members may want, or need, to pay for with the insurance.

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Would you want to take time off from work if a spouse died? Pay off the mortgage (or just receive enough to continue making payments)? Pay for a portion or all of college? Are there any debts that would need to be repaid?

Working parents should buy enough insurance to replace their income for five to 20 years, depending on how old their children are and whether a spouse or partner could support the children on one income. For a stay-at-home parent, you should consider the cost of hiring someone else to perform all of your daily duties. The costs can add up, particularly when considering child care, buying and preparing meals, chauffeuring children around and the overall job of keeping a household running.

One policy or more?

Families' needs will probably change over time, so some individuals may consider buying policies with different expiration dates: maybe a $1 million policy with a 20-year term that gets the children through college and another $500,000 policy with a 30-year term that gets you to retirement.

It is usually cheaper to buy term insurance in bulk, so it may not be cost-effective to buy policies in increments of less than $500,000.

Buy the policy as soon as the need arises, or even earlier. Pregnant women, particularly late in their pregnancies, may pay more because of their weight and naturally elevated cholesterol levels.

Whom to name as beneficiary?

The easiest alternative for a happily married couple is to name one another as the beneficiary.

But if both parents die and a minor child is named as a contingent beneficiary, or if a single parent names a child as a beneficiary, matters can get complicated. Surrogate courts will probably get involved.

The simplest and most inexpensive way to avoid this situation is to have the policyholder's will create a testamentary trust after the holder's death. The trust is named as the beneficiary, providing instructions for a named trustee.

But that's not the only option. An individual can also create a revocable living trust, which essentially serves as a will but has the added benefit of avoiding probate, the sometimes-lengthy court-directed process to settle a will. Unlike a will, the trust remains private and doesn't become a public record, as long as it's properly funded.

Then there's the bulletproof option. Parents can name an irrevocable life insurance trust as the owner and beneficiary of the policy. Not only does that protect the money from creditors (helpful for doctors subject to malpractice suits), it also removes the proceeds from the estate for tax purposes.

Life insurance proceeds aren't subject to income taxes, but the amount is included in the deceased's estate.

That isn't a problem for most people, now that the federal estate tax exemption is $5.45 million (double that for married couples). And while there are states with far lower exemptions for state estate taxes — New Jersey is a mere $675,000 and Massachusetts is $1 million — many families don't set up trusts to avoid those taxes.

Why? Assets left to a spouse are not subject to estate taxes. And the surviving spouse is likely to spend a big chunk of the insurance money anyway. But state estate taxes could become an issue, at least in certain states, if both parents died with substantial policies.

Where to buy it?

It pays to shop around to see which insurer offers the best price for specific circumstances. And instead of working with a broker exclusively affiliated with a single insurer, work with an independent agent who has access to the top term insurance providers.

That's important because some insurers may provide better pricing for people who are overweight, while others may be more competitive for policyholders, say, in their 40s and 50s. A.D. Financial planning has relationships with insurance brokers and can make recommendations for you. 

Then there's the online route. AccuQuote is an independent brokerage that has been selling life insurance online since the Internet was in its infancy. PolicyGenius is a newer entrant with easy-to-use calculators that help determine how much you need, factoring in estimates like the cost of fully funding college.

Both AccuQuote and PolicyGenius provide quotes only from providers with strong financial ratings, generally above an A−. But consumers can check an insurer's rating on their own through services like A.M. Best, which tracks the financial stability of insurers.

What about just buying coverage through an employer? It's usually not a good idea.

If you're healthy, individually underwritten coverage is better than group because employer-provided group coverage doesn't usually require a medical exam, so workers pay a bit more to account for less healthy people in the mix. Also, employer policies are generally not portable if you switch jobs.

But the biggest mistake people with dependents can make, however, is not buying any term insurance at all.

Contact us, A.D. Financial Planning can help you choose insurance that is right for you!

Your personality can make a difference when choosing a Roth or traditional IRA or 401(k).

When you think about making a financial decision, you might imagine poring over a spreadsheet or crunching numbers on a calculator. But you might be better off with a mirror than an abacus. That’s because making smart choices about money requires more than just math: Understanding your “financial personality” can go a long way toward helping you make better decisions. Are you a big spender or a dedicated saver? Do you use up all your disposable income or do you always manage to put something away for a rainy day? Your answers could make some ways of saving for retirement far more effective for you than others.

What shapes your financial personality? For most people, spending, saving, and investing have as much do do with emotion as math. Money is a very personal topic. Some people manage their finances like a tight ship. These highly motivated savers tend to be very organized, disciplined, and methodical about their finances and are generally better about putting money away. One reason is they have good “future time perspective,” which helps them see the value of waiting for something rather than insisting on immediate gratification. But for everyone who approaches money with this kind of rigor, there are plenty of other folks out there who are more impulsive, place a greater value on enjoying their money in the here and now, or struggle to stick to their budget. 

To see how financial personality can dictate better ways to save, take a look at the following case study. Using hypothetical investors, this study illustrates how some personality factors may determine whether it’s better to save in a Roth (after-tax) or traditional IRA, 401(k), or 403(b) (pretax).

Personal implications: Roth or traditional?

Conventional wisdom tells you to consider your tax rate today and in retirement to help determine whether making Roth or traditional pretax contributions to a 401(k) or IRA would make more sense. But tax rates don’t tell the whole story; personality could also be a consideration. Your propensity to spend or save your disposable income could also play a role in which type of account may better help you prepare for retirement. 

Here’s why: Generally, contributions to a traditional IRA, 401(k), or other workplace savings account can help lower your taxable income if certain requirements are met. But any money you save on taxes can help you improve your retirement readiness only if you’re disciplined enough to put your tax savings back into your retirement plan. If you get a refund and go out and spend it, it’s not going to help you be ready for retirement.

With Roth contributions—to an IRA or 401(k)—you have to pay taxes on your contributions up front. That takes away from your disposable income. With a Roth 401(k) your contributions and your taxes are coming out of your paycheck each pay period. With a Roth IRA, your contributions come from after-tax savings. But, if you’re like most people, who tend to spend what they earn anyway, having less disposable income might be a good thing when it comes to your retirement savings. You’ve already paid your taxes, so you get to take your money out tax free,¹ which could leave you more to spend in retirement. In a sense, says Kenigsberg, “a Roth 401(k) forces you to save more for later by keeping less in your pocket now.”

To see how this scenario might actually play out in terms of numbers—and potentially increased savings—consider three hypothetical investors, Brian, Sara, and Jeff, who all have certain things in common:

• Age: 45
• Plan to retire at: 65
• Gross household income (both spouses' salaries): $125,000
• Marginal tax rate: 28%*
• Expected marginal income tax rate in retirement: 28%
• Hypothetical pretax return on investments: 7%
• Hypothetical after-tax return on investments: 6%

But, they each have very different financial personalities.

Brian is very frugal and an extremely disciplined saver who contributes to a traditional pretax 401(k). He tracks every penny, and if he finds himself with some money he hasn’t budgeted at the end of the month, he invests all of it. Same goes for tax returns, bonuses, and any windfalls. That’s admirable, but probably a little unusual.

Sara, like a lot of people, tends to spend whatever she has left in her paycheck, so while she too contributes to a pretax 401(k), when she gets a tax refund or has money left over at the end of the month, she doesn’t save a penny. Instead, she uses it to pay for a much-needed vacation or a night on the town.
 
Jeff has a lot in common with Sara; he knows he’ll spend money if he’s got it. So he saves through a Roth 401(k) instead and gets his income tax payments out of the way now, hoping to have more income available in retirement.

Let’s assume they each invest $5,000 in their 401(k) when they are 45 years old and won’t need the money until 10 years after they retire, when they are age 75. That’s a 30-year time horizon. Let’s also assume that Brian and Sara each receive a $1,400 tax refund as a direct result of their 401(k) contributions, while Jeff doesn’t receive a refund because his Roth IRA contribution doesn’t reduce his taxable income. How much would they each have after 30 years, based on the type of 401(k) account they chose, and whether they saved or spent their tax refund? Take a look:

As you can see, Sara ends up with the least amount of savings since she chose the pretax 401(k) but spent her entire refund. Her account grows just like Jeff’s, at 7% annually, but she then has to pay more than $10,657 (or 28%) in taxes as she withdraws the money in retirement. Brian does much better than Sara: After paying taxes in retirement, he ends up with the same $27,404 from his 401(k) that she does, but he also invests his refund in a taxable brokerage account. In this example we assume Brian’s taxable account will have grown at 6% annually. Why the lower rate? Because as Brian invests, he may have to pay taxes. For this example, we are estimating those taxes will reduce his investing performance from 7% to 6%. At 6%, Brian will have $8,041 in his taxable account, so he’ll have a total of $35,445. Jeff does even better than Brian—the $5,000 in his Roth 401(k) has also grown at 7% annually, to $38,061, and he doesn’t have to pay any tax on withdrawal. 

In effect, the Roth 401(k) gave Jeff two big advantages that account for the difference: First, the Roth captured all of Jeff's tax savings in the plan—safe from his temptation to spend it before retirement. And second, all of Jeff’s assets were in the retirement account enjoying the highest rate of return in this hypothetical example. Of course, Sarah could make up the difference by boosting her contributions—but only if she were not prevented from doing so by contribution limits, and only if she took the time to figure out how much to increase her contributions. For Sara, increasing her contributions from $5,000 to $6,944 would leave her with the same balance as Jeff. 

This example shows that a Roth 401(k) might actually be an easier way to realize your savings goals by 1) making you pay your income taxes at the same time you contribute, 2) limiting the disposable income available for you to spend, and 3) allowing you receive tax-free distributions and potentially make a higher return on your investments. And, given that most people tend to spend what they earn, having less in your pocket now leads to more in your pocket during retirement.

Clearly, many factors determine what might be the best way for you to save for retirement—from what you can afford to your risk tolerance and tax situation. You might not typically think beyond numbers and facts to make saving decisions, but, given this illustration, maybe you should. Personality can play a role in how effectively you save for the future. Not just in terms of whether or not you save, but more importantly how you do it. And that gives a whole new meaning to the idea of “personal” finance.

To discuss retirement savings or just where to begin on your path to financial freedom, contact A.D. Financial Planning.

1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first-time home purchase.

*Assumed tax rate.

References: What's your savings style? (2011). Retrieved April 20, 2012, from https://www.fidelity.com/viewpoints/traditional-or-roth

The most common mistakes an investor can make, especially a high-net-worth investor, is to overlook the potential impact taxes can have on investment returns. In fact, Morningstar cites on average, over the 74-year period ending in 2010, investors who did not manage investments in a tax-sensitive manner gave up between one and two percentage points of their annual returns to taxes.¹ So as the following chart shows, a hypothetical stock return of 9.9% that shrank to 7.8% after taxes would, in effect, have left the investor with 2.1% less investment income in his or her pocket.

Taxes are not as inevitable as you might think. With careful and consistent planning, you can potentially reduce their impact on your returns through tax-efficient investing. Contact A.D. Financial Planning to help you make the right tax moves for your particular situation—or to confirm that your current approach is still sound. Below, are some possible tax-smart strategies to consider to help you prepare for a productive discussion with us.

20-year U.S. government bond. Inflation is represented by the Consumer Price Index (CPI), which is a widely recognized measure of inflation, calculated by the U.S. government. Please note that indexes are unmanaged and are not illustrative of any particular investment. It is not possible to invest directly in an index. © 2011 Morningstar, Inc. All rights reserved. 3/1/11. Analysis of historical performance by the research firm Morningstar highlights the potential impact of taxes on investment performance. 1* Past performance is no guarantee of future results. This chart is for illustrative purposes only and does not represent actual or future performance of any investment option. Returns include the reinvestment of dividends and other earnings. Stocks represented by the Standard & Poor's 500 Index (S&P 500®). It is an unmanaged index of the common stocks prices of 500 widely held U.S. stocks. Bonds are represented by the 20-year U.S. government bond. Inflation is represented by the Consumer Price Index (CPI), which is a widely recognized measure of inflation, calculated by the U.S. government. Please note that indexes are unmanaged and are not illustrative of any particular investment. It is not possible to invest directly in an index. © 2011 Morningstar, Inc. All rights reserved. 3/1/11.

First, consider the accounts you invest in

Tax-free municipal bonds and money market funds

If generating income is one of your investment goals, you may want to consider tax-free municipal bond and money market funds, especially if you’re in a high tax bracket. These funds typically invest in bonds issued by municipalities and their earnings are generally not subject to federal tax. You may also be able to avoid or reduce state income tax on your earnings if you invest in a municipal bond or money market fund that holds bonds issued by entities within your state. Interest income generated by most state and local municipal bonds is generally exempt from federal income and/or alternative minimum taxes. But if these bonds were used to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest is fully taxable for taxpayers subject to the AMT.

Interest dividends distributed by a municipal bond or money market mutual fund are also subject to the AMT if the fund owns certain private activity bonds. A fund's prospectus will tell you if it aims to generate only AMT-free interest dividends.²

Tax-advantaged retirement savings accounts
Choosing the types of accounts in which to invest can be as important to tax efficiency as the types of assets you put in those accounts. When saving for retirement, a qualified workplace savings plan, such as a 401(k) or 403(b) plan, allows you to contribute pretax dollars that can potentially grow on a tax-deferred basis until they’re withdrawn after age 59½. If your employer offers a Roth 401(k), you can avoid taxes entirely on your earnings, provided certain conditions are met, although your contributions would not be pretax or tax deductible in the year you make them. Similarly, a Roth IRA allows your investments to grow tax-free, but there are income limits for contributions. If your income exceeds the limit and you or your spouse is not covered by a retirement plan at work, you may contribute to a traditional IRA for tax-deferred savings. Roth IRAs are now available to many investors and a new law allows workplace plan participants to directly convert certain plan assets in a 401(k) or 403(b) plan from a former employer to a designated Roth account, provided it is available in the plan. This may be good news for participants who are eligible for a distribution and want to keep their money in an employer plan rather than rolling it over to a Roth IRA.

If your employer offers you access to a health savings account (HSA) with a high-deductible health insurance plan, it’s a useful tool to potentially save on taxes while paying for qualified medical expenses.

Second, understand your asset allocation

Employing an asset location strategy

A well-thought-out asset allocation strategy can play a key part in helping to reduce a portfolio’s overall risk and boost reward potential. But there’s another important companion strategy that many investors often overlook. Known as “asset location,” it involves deciding which investments within your asset allocation are held in taxable, tax deferred, or tax free accounts. This strategy can potentially help reduce the tax impact. A.D. Financial Planning believes asset location is a key strategy in managing for tax efficiency, especially for affluent investors.

For example, you may want to consider whether it may be advantageous to give priority in your taxable accounts to relatively tax efficient investments, such as stocks or mutual funds that pay qualified dividends (as long as these rates remain in effect), equity index funds, and tax-managed stock funds. Similarly, it may make sense to use tax-deferred accounts such as defined contribution plans (401k, 403b, 457, etc.), traditional IRAs, and tax-deferred annuities for investments that generate high levels of ordinary income, such as taxable bond funds and real estate investment trusts (REITs), as well as, for any equity funds that tend to make large and frequent distributions of capital gains - particularly short-term capital gains.

Third, know when to hold or sell

Avoiding unnecessary short-term taxable gains

If you sell an investment within one year of purchasing it, you’ll likely owe more tax on your capital gain than if you held it for more than a year. So-called “short-term” capital gains are taxed at the same rate as your ordinary income, as much as 35% in 2010. The top tax rate on “long-term” capital gains is 15%. You should check to see if any of the investments you own may be worth holding for longer periods of time to avoid short-term capital gains. Of course, you should keep in mind the risk of holding these investments, and understand how they fit in your overall portfolio. If the risk outweighs the potential tax hit, it may make sense to sell. Additionally, check current tax rates for the right move; tax codes are constantly changing.

Offsetting capital gains with capital losses

Suppose you want to sell stock that has substantially increased in value in order to use the proceeds for a one-time expense, such as purchasing a vacation home or paying your grandchild’s college tuition. To offset a large tax liability on your capital gain, you could sell an investment that has lost value. But, if the losing investment was important to maintaining your portfolio’s asset allocation, you may want to purchase a different investment in the same asset category. Just be aware of wash sale rules that may prevent you from claiming a capital loss.

Capital loss carry-forwards

If your capital losses exceed your capital gains in a given year, you can generally deduct up to $3,000 of the excess from your ordinary income in that year. If you have more than $3,000 in excess losses, you’re able to carry forward those losses into future years.

Stay disciplined

References: Reduce the tax hit on investments (2011). Retrieved April 20, 2012, from https://www.fidelity.com/viewpoints/tax-efficient-investing

The importance of asset allocation

When building a portfolio to meet a specific objective, it is critical to select a combination of assets that offers the best chance for meeting that objective, subject to your constraints.² Assuming that you use broadly diversified holdings, the mixture of those assets will determine both the returns and the variability of returns for the aggregate portfolio.

This has been well documented in theory and in practice. For example, in a paper confirming the seminal 1986 study by Brinson, Hood, and Beebower, Wallick et al. (2012) showed that the asset allocation decision was responsible for 88% of a diversified portfolio's return patterns over time:

Investment outcomes are largely determined by the long-term mixture of assets in a portfolio

Note: Calculations are based on monthly returns for 518 U.S. balanced funds from January 1962 through December 2011. For details of the methodology, see the Vanguard research paper The Global Case for Strategic Asset Allocation (Wallick et al., 2012). Source: Vanguard calculations using data from Morningstar.

In the illustration following we show a simple example of this relationship using two asset classes—U.S. stocks and U.S. bonds—to demonstrate the impact of asset allocation on both returns and the variability of returns. The middle numbers in the chart show the average yearly return since 1926 for various combinations of stocks and bonds. The bars represent the best and worst one-year returns. Although this example covers an unusually extended holding period, it shows why an investor whose portfolio is 20% allocated to U.S. stocks might expect a very different outcome from an investor with 80% allocated to U.S. stocks.

Stocks are risky—and so is avoiding them

Stocks are inherently more volatile than investments such as bonds or cash instruments. This is because equity owners are the first to  realize losses stemming from business risk, while bond owners are the last. In addition, whereas bond holders are contractually promised a stated payment, equity holders own a claim on future earnings. But the level of those earnings, and how the company will use them, are beyond the investor's control. Investors thus must be enticed to participate in a company's uncertain future, and the "carrot" that entices them is higher expected or potential return over time.

The following chart also demonstrates the short-term risk of owning stocks: Even a portfolio with only half its assets in stocks would have lost more than 20% of its overall value in at least one year. Why not simply minimize the possibility of loss and finance all goals using low-risk investments? Because the attempt to escape market volatility associated with stock investments by investing in more stable, but lower-returning, assets such as Treasury bills can expose a portfolio to other, longer-term risks.

The mixture of assets defines the spectrum of returns: Best, worst, and average returns for various stock/bond allocations, 1926–2012

Note: Stocks are represented by the Standard & Poor's 90 Index from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 to 1968; the Citigroup High Grade Index from 1969 to 1972; the Barclays U.S. Long Credit AA Index from 1973 to 1975; and the Barclays U.S. Aggregate Bond Index thereafter. Data are through December 31, 2012. Source: Vanguard.

One such risk is "opportunity cost," more commonly known as shortfall risk: Because the portfolio lacks investments that carry higher potential return, it may not achieve growth sufficient to finance ambitious goals over the long term. Or it may require a level of saving that is unrealistic, given more immediate demands on your  income or cash flow (in the case of an endowment or pension fund, for example). Another risk is inflation: The portfolio may not grow as fast as prices rise, so that you lose purchasing power over time. For longer-term goals, inflation can be particularly damaging, as its effects compound over long time horizons. For example, Bennyhoff (2009) showed that over a 30-year horizon, an average inflation rate of 3% would reduce a portfolio's purchasing power by more than 50%.

For investors with longer time horizons, inflation risks may actually outweigh market risks, often necessitating a sizable allocation to  investments such as stocks.

Use reasonable assumptions in choosing an allocation

Just as important as the combination of assets that are used to construct a portfolio are the assumptions that are used to arrive at the  asset allocation decision. By this we mean using realistic expectations for both returns and volatility of returns. Using long-term historical data may serve as a guide, but you must keep in mind that markets are cyclical and it is unrealistic to use static return assumptions. History does not always repeat, and the market conditions at a particular point in time can have an important influence on your returns.

For example, over the history of the capital markets since 1926, U.S. stocks returned an average of 10.0% annually and U.S. bonds 5.5% (based on the same market benchmarks used in the illustration above). For this 86-year period, a half-stock, half-bond portfolio would have returned 8.3% a year on average if it matched the markets' return.

But look at a shorter span, and the picture changes. For example, from 1980 through 2012, U.S. stocks returned an average of 11.1% a year, while bonds returned 8.5%. A portfolio split evenly between the two asset classes and rebalanced periodically would have generated an average annual return of 10.2%. As you can see, anyone with such a portfolio over this particular period could have earned nearly 2 percentage points a year more than the long-term historical average. Contrast that with the period from 2000 through 2012, when U.S. stocks provided a 2.3% average return and U.S. bonds 6.3%; then the same balanced portfolio would have averaged 4.9% a year.

In practice, you will always need to decide how to apply historical experiences to current market expectations. For example, as reported in Vanguard's 2013 Economic and Investment Outlook, returns over the next decade may look very different from the examples above as a result of current market conditions. Particularly for bonds, the analysis provided in the paper suggests that returns may be lower than to what many investors have grown accustomed. The implication is that investors may need to adjust their asset allocation assumptions and contribution/spending plans to meet a future objective that could previously have seemed easily achievable based on historical values alone.

Diversify to manage risk

Diversification is a powerful strategy for managing traditional risks.³ Diversifying across asset classes reduces a portfolio's exposure to the risks common to an entire class. Diversifying within an asset class reduces exposure to risks associated with a particular company, sector, or segment.

In practice, diversification is a rigorously tested application of common sense: Markets will often behave differently from each other—sometimes marginally, sometimes greatly—at any given time. Owning a portfolio with at least some exposure to many or all key market components ensures the investor of some participation in stronger areas while also mitigating the impact of weaker areas. 

Performance leadership is quick to change, and a portfolio that diversifies across markets is less vulnerable to the impact of significant swings in performance by any one segment. Investments that are concentrated or specialized, such as REITs, commodities, or emerging markets, also tend to be the most volatile. This is why we believe that most investors are best served by significant allocations to investments that represent broad markets such as U.S. stocks, U.S. bonds, international stocks, and international bonds.

Although broad-market diversification cannot insure an investor against loss, it can help to guard against unnecessarily large losses. One example: In 2008, the Standard & Poor's 500 Index returned –37%. However, more than a third of the stocks in the index that year had individual returns worse than –50%.⁴ Some of the worst performers in the index would probably have been viewed as "blue chip" companies not long before. They were concentrated in the financial sector, considered a staple in many dividend-focused portfolios:

The ten worst and best stocks in the S&P 500 Index in 2008

Sources: FactSet and Vanguard.